Launching off a stable inflation springboard

Central banks have done a remarkable job of controlling inflation since the crisis. But with unemployment still high, fear of a credit bubble must not deter further expansion.

Why are the high-income countries not mired in deflation? This is the puzzle today, not the absence of the hyperinflation that hysterics have wrongly expected. It is weird that inflation has remained so stable, despite huge shortfalls in output, relative to pre-crisis trends, and prolonged high unemployment. Understanding why this is the case is important because the answer determines the correct policy action. Fortunately, the news is good. The stability of inflation seems to be a reward for the credibility of inflation targeting. That gives policy makers room to risk expansionary policies. Ironically, the success of inflation targeting has revitalised Keynesian macroeconomic stabilisation.

A chapter in the latest World Economic Outlook from the International Monetary Fund presents the case for this encouraging conclusion, as has already been noted by, among others, Gavyn Davies and Paul Krugman. Its starting point is with the stickiness of inflation, despite the lengthy period of very high joblessness. Thus, states the IMF, “we find a dog that did not bark”.

A possible explanation for this phenomenon is structural. It is argued by many, for example, that the workers who lost their jobs in construction and other bubble-era activities have the wrong skills or are located in the wrong places to take up the new jobs that might now – or soon – be on offer. Again, if unemployment is allowed to remain high for long, what starts as temporary joblessness is likely to become permanent, as workers lose the skills and networks that make it relatively easy to find jobs. So the duration of the Great Recession has put long-term joblessness near record levels. All this tends to make competition in labour markets weak.

An alternative explanation is more encouraging. It is that inflation targeting has anchored expectations and so labour market behaviour. Moreover, these targets are close to zero. We know that workers are resistant to cuts in nominal wages. This has remained true throughout the Great Recession: it is indeed one of the reasons why the adjustment in the eurozone is so painful. So, for this reason too, inflation would be sticky, at least downwards.

The chapter’s preliminary analysis of these alternatives reaches three main conclusions. The first is that “expectations are strongly anchored to the central banks’ inflation targets rather than being particularly affected by current inflation levels”. Second, the anchoring of expected inflation has increased over time, while the impact of current inflation on expected inflation has diminished. Finally, the relationship between inflation and current unemployment has correspondingly diminished. It became nearly non-existent after 1995, which saw a long period of stable inflation in line with the inflation targets of central banks.

The detailed econometric work supports this preliminary analysis, but adds two further points. The most important is that there is substantial cyclical unemployment, at present. A less important one is that the impact of global inflation on inflation in individual countries has not shown any clear trend.

An analysis of the US reveals the import of these changes: if the relationship between the cycle and inflation were now as it was in the 1970s, the US price level would already be falling. Fortunately, that has not been the case: otherwise, real rates of interest would now be strongly positive and balance-sheet deflation far more threatening to US stability than it has been. Encouragingly, experience during the period of economic boom, before the financial crisis, suggests the stickiness of inflation does not only work in one direction. Inflation remained in line with targets then, too. This was notably true in Spain and the UK.

A final interesting conclusion emerges from the contrast between the performance of the US and Germany in the 1970s, which was when the Bundesbank cemented its reputation. It did not achieve this success because it never made mistakes, but because people believed it would do what was necessary to hit the target. Inflation targeting could indeed be flexible, provided it remained credible.

This is important analytical work with big implications for policy.

Firstly, mistakes in estimating the degree of economic slack, which are inevitable, may not matter that much, provided people remain sure that the central banks are committed to their targets. This is one of the big benefits of a flat 'Phillips curve' (the relationship between cyclical unemployment and inflation).

Secondly, given the uncertainty about the degree of slack and the failure of inflation to respond to huge recessions, it is imperative that central banks not limit their aims to hitting their inflation targets. On the contrary, their job in a deep recession and, in some countries, alas, a worsening one, is to aim for the highest levels of activity consistent with stable inflation. Past success gives them not only the opportunity, but the obligation, to risk expansion of demand in contractionary times. Those running the European Central Bank, please note: low inflation is not enough.

Third, while central banks should retain inflation targets at the core of their objectives, experience has also demonstrated that this is not enough. The idea that it is easier to clean up after a financial mess than limit a credit bubble has proved wrong. The only question is how to act. It is clearly important to build a more resilient financial system, through higher capital standards and aggressive macroprudential policies.

None of this is going to be easy. A chapter in the companion Global Financial Stability Report brings out, for example, the potential drawbacks of the unconventional policies that central banks were driven to use once interest rates became close to zero. While changing inflation targets would be extremely risky, what has happened suggests that somewhat higher inflation might have been helpful. Experience certainly indicates that monetary policy is not all that effective, on its own, during a balance-sheet recession. It must be complemented by fast reconstruction of the financial system, accelerated private sector deleveraging and a willingness to employ the fiscal balance sheet to support demand, wherever feasible.

Yet, for all the complacency of the pre-crisis period, it is good to know that this one clear success – that of cementing inflation expectations – has given policy makers needed flexibility. They must use it.

Martin Wolf - Financial Times

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